Central and Eastern Europe: Moving up the value chain

With investment from and export markets in the Eurozone stalling, Central and Eastern Europe (CEE) is looking to shift its focus of growth toward higher-value production and services. This is a bold step for a region that has, up until now, relied heavily on low labour costs to fuel foreign investment. In this fourth article, we look at the challenges and opportunities ahead for countries in the region and foreign investors as CEE prepares to carve out an ambitious new economic path.

Over the past two decades, EU investors and consumers have helped drive growth in CEE, leaving this region especially vulnerable to the protracted Eurozone crisis. In response to the crisis, governments in the region have been forced to reorient their growth strategies to focus on developing more resilient sectors and attracting investors outside of the EU. In recent months, a new trend has emerged: a move away from reliance on foreign direct investment (FDI) in low-cost labour production toward strategic FDI, emphasising high-quality labour forces, excellent infrastructure and technological support. On the surface, the shift may seem like a minor adjustment of policies that support export-orientated FDI, but it is in fact a strategic turn of the entire FDI framework toward high value-added production.

Opportunities are emerging in the region for investors seeking strategic assets crucial for high value-added sectors. As companies weigh various investment opportunities, fundamentals such as political stability and a sound regulatory framework will be crucial, as will the capacity of individual governments to implement the institutional and policy changes necessary to build a knowledge economy.

Low labour costs drive investment

When CEE economies opened to FDI after the fall of communism, foreign investors enjoyed a plethora of opportunities. The core countries of the EU comprised the region’s primary investors, and they also became the main consumers of the CEE countries’ products and services. German manufacturing companies, most notably car manufacturers and food producers, moved first into CEE markets.

FDI proved to be vital in facilitating the modernisation, restructuring and privatisation of the previously centrally planned economies of CEE countries. With this infusion of FDI came new technology and skills, increased productivity and jobs. The winners in this round of FDI competition were the countries with solid manufacturing track records that are located closest to the western EU markets: the Czech Republic, Hungary, Slovakia and Poland. As Figure 1 illustrates, the correlation between real GDP and inward FDI was very strong in the CEE region between 1990 and 2005,1 suggesting that FDI was crucial to economic growth in these countries. These developments encouraged governments to align their regulatory and incentives frameworks toward foreign investors, resulting in regional competition for investment. As a result, CEE countries developed an almost uniform model of export-oriented investment in low-skilled production, including policies focused on infrastructure investment, build-up of industrial parks and incentives for investors in the form of cash subsidies or tax breaks.

Figure 1: GDP growth and Inward FDI flows

Figure 1: GDP growth and Inward FDI flows

Western European investors benefited from the convenient geographical location, comparatively low labour costs, lower overall production costs and high-quality products in CEE economies. Investors’ business strategies typically focused on producing manufactured goods for export. Notable exceptions to this pattern were investments into underdeveloped financial sectors and infrastructure, which, by their very nature, service the domestic market. The CEE countries competed fiercely among themselves for each and every investor, thereby putting businesses in a strong position, with leverage to negotiate the best possible conditions, investment incentives or subsidies from their host governments.

The Eurozone crisis spurs a rethink

The 2008–2009 global financial crisis and the ensuing Eurozone sovereign debt crisis have proved that FDI in CEE countries is highly vulnerable to economic downturns. The share of FDI as a percentage of GDP peaked between 2005 and 2007, but has dropped significantly over the past few years. The European economic downturn and the Eurozone crisis have created difficulties for many European companies. Banks have reduced their lending and consumers lessened their demand for goods and services.

These circumstances have prompted rapid capital flight from the CEE region and decreased demand for the exports on which these countries’ economic growth models depended. Exports remain subdued at present amid the ongoing turmoil of the Eurozone crisis and FDI has failed to recover substantially as European companies continue to pursue cautious business strategies in an uncertain economic environment. In a sharp contrast to the pre-crisis period, almost all CEE countries currently trend below the EU average in terms of FDI. For companies seeking new investments, this situation creates an opportunity to take advantage of a strong negotiating position as countries once again compete with each other for a limited pool of FDI (see Figure 2).

Promoting the Czech Republic’s new FDI strategy

The framework of the Czech Republic’s FDI strategy has shifted from low-cost, labour-reliant manufacturing toward high value-added sectors. An incentive scheme introduced in July explicitly promotes technological and strategic service centres. It offers the same advantages in terms of cash subsidies on investment and tax breaks as was previously extended only to manufacturing companies. The Czech Invest Agency’s priority sectors now comprise software and information and communications technology services, business support services, advanced renewable energy and clean technologies, nanotechnology, aerospace, advanced automotive, life sciences, electronics and industrial machinery sectors. The agency’s latest project, Czech Link, is a merger and acquisitions support programme centred on these industries. Publicity material highlights the opening of R&D centres and energy research clusters, as well as the successes of the Silicon Valley–based Czech Accelerator project for innovative Czech start-ups.

And it is not only the Czech Republic making such advances. Its regional peers are undergoing change, too: Slovakia promotes its university-linked centres of excellence, Latvia provides recruitment support for sophisticated business process outsourcing and Estonia is calling for the next EU budget (2014–2020) to focus on the support of smart economic growth.

Moving up

However, governments across the CEE region are not competing with one another in the same way as before. The Eurozone crisis has spurred them to rethink their FDI strategies. Empirical observation, as well as economic data, suggests that high value-added sectors have been considerably more resilient to the crisis than those relying on low-cost manufacturing. In Bulgaria, for example, the economy contracted from 6.4% growth in 2007 to -5.5% in 2009 and only last year recovered to 1.7% growth.2 However, Bulgaria’s information and communications technology (ICT) sector expanded throughout the crisis, achieving 5% growth in 2011, and its contribution to Bulgaria’s economy rose to almost 10% of total GDP.3 Countries across the region recorded similar experiences in other high value-added sectors such as custom software development, sophisticated manufacturing, nanotechnology and clean energy technology. Shared experience motivated governments across the region to redirect their FDI strategies and launch new campaigns to attract investors.

This opens up a new round of investment opportunities in the region, as CEE governments aiming to attract capital and generate growth are once again racing to offer the best conditions for foreign firms. Given that governments tend to rely on supply-side measures to motivate export-oriented FDI, investors in high value-added sectors will be able to take advantage of these schemes and measures, and in many cases negotiate additional advantages. Investment incentive frameworks, which have typically been the most widely used supply-side measure in the CEE region, are now being tailored to accommodate high value-added projects—for instance, by reducing the size of eligible projects (since high value-added investments tend to be smaller) and introducing new schemes for small businesses and for cross-border mergers and acquisitions (since high value-added firms are often new and innovative and have steep costs). New industrial parks focusing explicitly on sophisticated business process outsourcing, software development or biotechnology are being constructed throughout the region. And authorities are seeking to highlight these policy changes. For example, investment agencies have switched from stressing low labour costs to promoting the high quality of the workforce (volume of science graduates, high numbers of PhD researchers and advanced language skills of the population). Meanwhile, nanotechnology colloquiums have replaced manufacturing fairs.

Figure 2: FDI as % of GDP

Figure 2: FDI as % of GDP

Attracting fresh investment

These new FDI frameworks face a sizable challenge. Virtually all investment in CEE countries over the past two decades originated in the EU. While CEE governments tend to be the most comfortable with EU investors, the lingering Eurozone crisis is forcing CEE officials to look significantly further afield to capitalise on their newly developed strategies. So firms based outside of the EU may now find investing in CEE economies easier and more appealing, as they will enjoy the same benefits (political stability, quality infrastructure and favourable regulations) as do companies from the EU.

CEE governments are forging relationships with investors in countries such as China, Qatar and Israel. With regards to China, governments are attempting to develop investment relationships with various companies, building on strong (albeit unbalanced) trade relations with Beijing. One of the latest examples is the declared interest of a Chinese investment fund in Burgas, Bulgaria’s fourth-largest city (see box below). CEE countries are also vying to attract Qatari attention. This includes competing to sign cooperation agreements, opening embassies and sending business delegations to the Gulf kingdom. CEE countries are targeting Israel specifically for its expertise in R&D and technology as growth sectors. Thus far, success has been relatively limited, so the impact of new investors in the region is likely to remain modest in the near future.

Bulgaria’s experience highlights challenges

Bulgaria has been setting the pace in seeking alternative sources of investment, as demonstrated by the recent announcement of Chinese investors’ interest in the Burgas industrial zone. Qatari investors, meanwhile, are reportedly considering launching ventures in Bulgaria in areas ranging from agriculture to infrastructure development.

But difficulties remain. Despite the country’s best efforts, Bulgaria’s once stellar ability to attract FDI started to yield strong results again only this year. In the first six months of 2012, the country attracted €810.1 million ($1.05 billion) in investment—still relatively low, but vastly higher than the €273.9 million ($353.34 million) it attracted a year ago. Approaching new investors has proven to be more difficult than building up relationships with existing ones and challenges remain in governance and the rule of law. Bulgaria’s efforts to build new relationships are likely to be rewarded only in the medium term, and require progress on regulatory reforms.

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Investment considerations

Businesses considering entering or strengthening their presence in CEE markets should take account of the differences in the foreign investment environments across the region. In general, CEE countries compare very well with other emerging markets when it comes to setting the preconditions for the development of high value-added sectors. A highly educated workforce is perhaps one of the most important qualities of the CEE labour market, which boasts some of the highest tertiary enrollment rates and researcher headcounts in the world.4 In addition, the growth of labour productivity in the region has outperformed that of most of the rest of the world in the past two decades. And general political stability and reliable infrastructure provide basic preconditions for successful business operations. Yet firms operating in the region will find that CEE countries share a common weakness—underdeveloped financial markets—and that modern technologies have only a limited impact on the development of business and organisational models in these states.

Despite these commonalities, CEE countries differ in many ways that potential investors should be aware of when assessing investment decisions. Regulatory quality and governance will remain key factors in investment decision-making for all businesses interested in the region. The regulatory environment and rule of law are most problematic in Romania and Bulgaria. The existing FDI base is also a major factor, as investors are more likely to roll out high value-added manufacturing in markets where this type of work has already been established.

Figure 3: Global Innovation Index 2012 rankings

Figure 3: Global Innovation Index 2012 rankings

Investors should also be aware of the strengths and weaknesses of various CEE countries with regard to different high value-added industries. As the innovation index in Figure 3 highlights, Estonia is, for instance, typically credited for fostering successful high value-added development in the region. The country deserves its high rankings for ICT services and software development. And Estonia’s internet connectivity and creativity in developing online content remain unrivalled in the CEE region. Estonia, nonetheless, has the lowest number of science-related graduates in the region and lags behind some of its neighbours in healthcare-related sectors such as pharmaceutical development and laser optics equipment manufacturing. Slovenia lags behind Estonia’s emerging strength in software, but it leads on R&D in terms of numbers of researchers and expenditure as a share of GDP. At the same time, the Czech Republic has been building on its traditional strength in engineering and applied science, placing emphasis on the development of new capacities in sectors such as nanotechnology and aeronautics. Latvia excels in environmental and sustainability projects, and Slovakia at advanced automotive manufacturing; Lithuania positions itself as a regional leader in life sciences and laser optics, and Romania is a leader in the area of environmentally friendly production.

In the competition for FDI opportunities in the CEE region, investors in high value-added sectors can benefit from governments’ policy redirection, as well as individual countries’ existing strategic assets. But to make the best of these emerging opportunities, strategic planning and decision-making should be supported by a detailed analysis of the specific political risks and regulatory environments of individual countries, as their characteristics differ across sectors. Even though the Czech Republic and Estonia are currently the front-runners for investor attention, other countries in the region can provide better operating environments in particular sectors (for example, it would be difficult to place a metallurgical research facility in Estonia). Moreover, companies looking to invest in the CEE region may find that the countries lagging just behind the front-runners can offer similar assets at a lower price or with added incentives for investors. In this regional competitive environment, the search for the best opportunities is likely to lead businesses beyond the obvious choices.

In conclusion, the strong fundamentals of political stability, a well-educated workforce and governments’ keenness to support incoming investment have opened up a valuable window of opportunity for technology and other high value-added businesses. Targeting is going to be crucial, with particular countries offering specific expertise. And in this fast-moving and highly competitive investment environment, the most attractive opportunities may be found among the up-and-comers rather than just the front-runners.